Who Wants to Bet against the Yield Curve: Is This Time Different?

Monday, September 30, 2019

By Carlos Garriga, Vice President and Economist, and Matthew Famiglietti, Research Associate

One of the most robust facts in economic cycles is that a yield curve inversion has occurred within two years of every U.S. recession since at least 1960. This phenomenon occurs when the yield of a shorter-maturity bond exceeds the yield of a longer-maturity bond, and it is widely considered one of the best leading indicators of U.S. recessions. Its predictive power has led the financial and economic communities to closely follow inversions.

Negative Territory for the Yield Curve

Starting in June, the monthly spread between the 10-year and three-month Treasuries became negative, and the monthly yield spread has not returned to its usual positive territory despite the recent cuts to the target range for the fed funds rate totaling 50 basis points since July.

Analysis of Yield Curve Inversions

In October 2018, we predicted that the yield curve would have an inversion in the summer of 2019.Famiglietti, Matthew; and Garriga, Carlos. “The data behind the fear of yield curve inversions.” FRED Blog, Oct. 11, 2018. Performing a historical analysis, we identified two common leading indicators of U.S. recessions:

Revisiting Yield Curve Analysis

With the new developments, we are revisiting the trends of these leading indicators and the yield curve. We performed analysis to determine what housing trends occurred in the run-up to this yield curve inversion.

The figure below shows the percentage change from a year ago for construction employment, manufacturing employment and housing permits. Additionally, we plotted the yield spread between the 10-year and three-month Treasuries.To make the series more easily comparable, we plotted housing permits on the right y-axis to more closely examine the dynamics of the other variables. These series are plotted from January 2018 to July 2019 to observe a longer macroeconomic cycle.

The traditional leading indicators of recession—construction employment and manufacturing employment—saw their growth rates slow but not decline prior to this yield curve inversion. However, expectations of the housing market (housing permits) began to decline nine months prior to the yield curve inversion. This plot seems to suggest a nearly contemporaneous narrowing of the yield curve spread and declining rate of change in housing permits.

Housing Cycles and Recessions

This most recent instance of yield curve inversion provides further empirical evidence for the theories that housing cycles anticipate recessions and that housing expectations will often lead yield curve inversions. Compared to previous occurrences, housing expectations declined sharply prior to the recent yield curve inversion, and construction and manufacturing sectors showed some sign of softening before and after the inversion.

While some other current macroeconomic readings (such as unemployment, inflation and consumer spending levels) are solid from a historical perspective, the figure suggests that things could worsen in the relatively near future.

Given the ample historical evidence, this seems to be a classic scenario surrounding a yield curve inversion before a recession. None of the leading indicators are clearly signaling that this time could be different.

4 To make the series more easily comparable, we plotted housing permits on the right y-axis to more closely examine the dynamics of the other variables. These series are plotted from January 2018 to July 2019 to observe a longer macroeconomic cycle.